Gaming Stocks, Where To Put Your Money

The gaming hardware and software industry has everything to worry about the latest NPD report, which says that U.S. sales of physical video games hardware and software in February fell 25% to $810 million. Whereas hardware sales fell by 36%, software sales were down by 27% and accessory sales dropped 3%. With many games requiring internet access to play them, gaming industry has undergone a paradigm shift in recent years - physical games now constitute only 50% of the total market.

What does the current trend mean to Electronic Arts (NASDAQ:EA)? Remember that Dead Space 3, published by Electronic Arts outsold Activision Blizzard's (NASDAQ:ATVI) Call of Duty Black Ops 2, and was the # 1 game in February 2013.

Electronic Arts

Electronic Arts is a developer, publisher and distributor of gaming software content and services for video game consoles, personal computers, mobile devices, electronic readers and the internet. Under its EA brand, the company offers games and related content under a variety of categories that include action-adventure, role playing, racing, and first-person shooter games. Its EA Sports brand offers a collection of sports-based video games, and related content and services comprising simulated sports based on real-world sports leagues, players, events, and venues, as well as casual games with arcade-style game-play and graphics.

In the most recent quarter the company beat analyst estimates and reported an EPS of $0.44. Quarterly revenue for the quarter was up almost 30% to $922 million but took a loss of $45 million in the quarter. Net income for FY ended March 2012, however, was $76 million.

EA is not a dividend paying company. YTD return to investors was a handsome 38.51%. Analysts expect 57.06% growth in earnings for FY 2013 (ending March 30, 2013) and an average annual growth of 13.60% in the long term (5 years).

The SimCity Debacle

Whereas Dead Space 3 was doing well in the physical games section, EA is facing a problem with its latest game, SimCity, which was eagerly awaited as the early reviews showered accolades. However, what could have been an instant success turned out to be a nothing short of a nightmare.

The game requires access to the company's servers where games are automatically saved and friends can build on regions together. Within a day of the launch (March 5, 2013), gamers were posting angry comments and by March 7 Amazon (NASDAQ:AMZN) stopped selling it. The problem: SimCity's requirement of being online always - either it was gross mismanagement on the company's part or fans overwhelmed the servers. The company refused refunds saying that it was adding more servers but at the same time suspending its online marketing campaigns.

The company is also looking at implementing micro transactions into all its future games. Micro transactions, as CFO Blake Jorgensen explains, is a built-in system in the game that requires gamers to pay for things as they go along; for buying a new character, going to the next level or buy a new weapon or whatever. It is a model that bodes well for investors but fans seems to be a bit wary. Inclusion of micro transactions in Dead Space 3 was not welcomed by fans but the company says that other EA franchises such as FIFA, Battlefield and The Simpsons: Tapped out were benefiting from it.

Despite these hurdles, EA is recommended as a strong buy and so is its competitor Activision Blizzard.

Activision Blizzard

Activision is best known for its blockbuster games such as Warcraft, World of Warcraft, StarCraft and Diablo and now, Call of Duty Black Ops 2. The company is partnering with developer Bungie for a soon to be released game, Destiny.

Valuation wise, Activision Blizzard is a much bigger company than EA - market cap of $16.32 billion against EA's $5.74 billion. For the quarter ended December 2012, Activision reported total revenue of $1.77 billion and EPS of $0.75, a quantum jump from previous quarter's $0.12 EPS. As against EA, Activision is a dividend paying company that pays an annual dividend. With the current dividend of $0.19 per share its dividend yield comes to 1.29%. In addition, ATVI stock returned 38.73% YTD to investors.

Conclusion

The gaming software and programming industry is changing fast as is evident from the shift from physical games to online games. In addition, there also seems to be a shift towards the mobile market and the freemium (or micro-transactions) model.

EA, which was primarily a maker of games meant for play on PC/gaming console has a tough road ahead going forward for transition to mobile gaming and freemium model as it is more accustomed to high per-game revenue than what micro-transactions and mobile gaming has to offer. On the plus side is the new console cycle - Wii U of Nintendo (OTCPK:NTDOY), PlayStation 4 of Sony (NYSE:SNE) and Microsoft's (NASDAQ:MSFT) yet to be launched new Xbox - can prove to be a shot in the arm for the company. EA also seems to be going all out in its efforts for going digital. Recently, the company announced completion of a software engineering project that allows access different platforms with a single identity regardless of the company operating it..

In addition, EA and ATVI have enough cash on their balance sheets (EA - $1.16 billion and ATVI- $3.96 billion) to invest in a new portfolio of popular franchises in addition to their existing offerings. Both EA and Activision have enough products in the pipeline. EA is releasing Army of Two The Devil's Cartel on March 26, 2013 and going all out to make it a hit.

Investors however need to look at the current valuations. EA is trading at a high P/E of 39.40. Activision on the other hand has a much favorable P/E of 14.47 suggesting that it is fairly valued. However, EA has better PEG (price/earnings to growth) ratio of 1.49 as compared to 2.23 of Activision suggesting better potential for appreciation in the long term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.